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8-2 Again, see the model in IFM13Ch08 BOC.xlsx. We show some alternative conditions, or
scenarios, and the stock price under those scenarios.
8-3 Again, see the model IFM13Ch08 BOC.xlsx. We show how to use Excel to find the stock
price under conditions of nonconstant growth. Note, though, that we do assume constant
growth after some number of years.
8-4 Again, see the model IFM13Ch08 BOC.xlsx. Everything up to this point could be found
fairly easily with a calculator, but it would be difficult to get an exact solution to Question
4 with a calculator. In the model, we show how to use Excel Goal Seek function to find
the expected rate of return.
8-5 The dividend growth model is only appropriate for companies that pay dividends and are
expected to grow at a predictable rate, with this rate leveling off to a constant rate sometime
in the future. It can also be applied to companies that do not pay dividends but are expected
to do so in the forecastable future, but here the analysis becomes more speculative.
It is especially difficult to justify using the discounted dividend model for tech stock
IPOs, where the company is not likely to ever pay a dividend because if it is successful it
is likely to be acquired in a merger. The acquisition price, if it could be estimated, and if
the timing of the acquisition could be forecasted, could be treated like a dividend, but this
is really stretching things.
For companies where the discounted dividend model is inappropriate, the free cash
flow valuation model in which we discount free cash flows, not dividends, is best. Free
cash flows can be calculated for any firm, whether it pays a dividend or not, so this model
is appropriate to all firms.
8-1 a. A proxy is a document giving one person the authority to act for another, typically the
power to vote shares of common stock. If earnings are poor and stockholders are
dissatisfied, an outside group may solicit the proxies in an effort to overthrow
management and take control of the business, known as a proxy fight. The preemptive
right gives the current shareholders the right to purchase any new shares issued in
proportion to their current holdings. The preemptive right may or may not be required
by state law. When granted, the preemptive right enables current owners to maintain
their proportionate share of ownership and control of the business. It also prevents the
sale of shares at low prices to new stockholders which would dilute the value of the
previously issued shares. Classified stock is sometimes created by a firm to meet
special needs and circumstances. Generally, when special classifications of stock are
used, one type is designated “Class A”, another as “Class B”, and so on. Class A might
be entitled to receive dividends before dividends can be paid on Class B stock. Class
B might have the exclusive right to vote. Founders’ shares are stock owned by the
firm’s founders that have sole voting rights but restricted dividends for a specified
number of years.
b. The free cash flow model defines the total value of a company as the value of operations
plus the value of nonoperating assets.
The value of operations is the present value of all the future expected free cash
flows when discounted at the weighted average cost of capital:
FCFt
Vop(at time 0) = .
t =1 (1 + WACC)
t
c. Constant growth occurs when a firm’s earnings, dividends, and free cash flows grow
at some constant long-term rate. In this situation, the constant growth model can be
used to estimate the present value of the growing cash flows or dividends. For free cash
flows, the present value is:
FCF1 FCF0 (1 + g L )
Vop (constant growth) = =
WACC − g L WACC − g L
^ = D0 (1 + g L ) = D1
P 0
rs − g L rs − g L
The horizon date is the last year in a cash flow forecast. Cash flows may grow
unevenly during the forecast period, but are assumed to grow at a constant rate for all
periods after the horizon date.
The horizon value is the value all cash flows beyond the horizon date when
discounted back to the horizon date.
When applied to free cash flows, the horizon value is the value of operations at the
end of the explicit forecast period. It is equal to the present value of all free cash flows
beyond the forecast period, discounted back to the end of the forecast period at the
weighted average cost of capital. Because growth after the horizon is constant, the
constant growth model can be applied at the horizon date:
FCFT +1 FCFT (1 + g L )
HVT = Vop(at time T) = = .
WACC − g L WACC − g L
When applied to dividends, the horizon value is the intrinsic stock price at the end
of the explicit forecast period. It is equal to the present value of all dividends beyond
the forecast period, discounted back to the end of the forecast period at the required
rate of return on stock. Because growth after the horizon is constant, the constant
growth model can be applied at the horizon date:
̂ T = DT+1 = DT (1+gL)
Horizon value for stock = P
rs -gL rs -gL
d. A multistage model is used when the growth rate is nonconstant for several years before
becoming constant. In this case, the constant growth model is applied at the end of the
forecast horizon when the growth rate has become constant. The total present value of
cash flows is the present value of all cash flows in the forecast periods plus the present
value of the horizon value:
T
FCF HV
Vop,0 = (1 + WACC
t + T
) (1 + WACC)T
t
t =1
T
D P̂
^=
P 0 (1 + tr ) t + (1 + Tr T
t =1 s L)
e. Estimated value ( P̂0 ) is the present value of the expected future cash flows. The market
price (P0) is the price at which an asset can be sold.
f. The required rate of return on common stock, denoted by rs, is the minimum acceptable
rate of return considering both its riskiness and the returns available on other
investments. The expected rate of return, denoted by ^rs, is the rate of return expected
on a stockn given its current price and expected future cash flows. If the stock is in
equilibrium, the required rate of return will equal the expected rate of return. The
realized (actual) rate of return, denoted by r̄ s, is the rate of return that was actually
realized at the end of some holding period. Although expected and required rates of
return must always be positive, realized rates of return over some periods may be
negative.
g. The capital gains yield results from changing prices and is calculated as (P 1 - P0)/P0,
where P0 is the beginning-of-period price and P1 is the end-of-period price. For a
constant growth stock, the capital gains yield is g, the constant growth rate. The
dividend yield on a stock can be defined as either the end-of-period dividend divided
by the beginning-of-period price, or the ratio of the current dividend to the current
price. Valuation formulas use the former definition. The expected total return, or
expected rate of return, is the expected capital gains yield plus the expected dividend
yield on a stock. The expected total return on a bond is the yield to maturity.
h. Preferred stock is a hybrid--it is similar to bonds in some respects and to common stock
in other respects. Preferred dividends are similar to interest payments on bonds in that
they are fixed in amount and generally must be paid before common stock dividends
can be paid. If the preferred dividend is not earned, the directors can omit it without
throwing the company into bankruptcy. So, although preferred stock has a fixed
payment like bonds, a failure to make this payment will not lead to bankruptcy. Most
preferred stocks entitle their owners to regular fixed dividend payments.
8-2 True. The value of a share of stock is the PV of its expected future dividends. If the two
investors expect the same future dividend stream, and they agree on the stock’s riskiness,
8-3 A perpetual bond is similar to a no-growth stock and to a share of preferred stock in the
following ways:
1. All three derive their values from a series of cash inflows--coupon payments from the
perpetual bond, and dividends from both types of stock.
2. All three are assumed to have indefinite lives with no maturity value (M) for the
perpetual bond and no capital gains yield for the stocks.
8-4 The first step is to find the value of operations by discounting all expected future free cash
flows at the weighted average cost of capital. The second step is to find the total corporate
value by summing the value of operations, the value of nonoperating assets, and the value
of growth options. The third step is to find the value of equity by subtracting the value of
debt and preferred stock from the total value of the corporation. The last step is to divide
the value of equity by the number of shares of common stock.
D1 $1.50
P̂0 = = = $21.43.
rs − g 0.13 − 0.06
8-3 P0 = $22; D0 = $1.20; g = 10%; P̂1 = ?; r s= ?
D1 $1.20(1.10)
rs = +g= + 0.10
P0 $22
$1.32
= + 0.10 = 16.00%. r s = 16.00%.
$22
D ps $5.00
rps = = = 10%.
v ps $50.00